## CONCLUSIONS ## Source details **Canonical URL:** [CONCLUSIONS](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11183.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11183.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11183.pdf.json) --- ### JAPAN’S ROLE IN THE WORLD ECONOMY - Japan is one of the largest and richest economies, a long-standing export powerhouse and the world‘s largest net creditor. - Longstanding current account surpluses since the 1970s contributed to Japan‘s creditor position. - The yen is a key international currency; several Japanese banks were once among the world‘s largest financial institutions. - The ―lost decade‖ of the 1990s, subsequent deleveraging, and adverse demographics have contributed to a more modest pace of economic expansion. ### Japanese Trade: High Value Added - Japan is a global supplier of high-end consumer goods and sophisticated intermediate products; upstream in regional production chains. - With the United States and China as largest trading partners, Japan accounts for about 5 percent of world trade. - Japanese imports from Asia rank third behind China and the United States; Japan‘s imports embody relatively low foreign value added in regional exports. - Example: Japanese companies account for about 10 percent of value added in Chinese exports of electrical equipment. - Key table and sector shares (selected entries preserved): - HS 8486 (mach & appl for mnf semiconductors): JPN exports = 34.3 percent of world exports. - HS 8408 (compression-Ignition engines): JPN exports = 10.0 percent of world exports. - HS 8541 (semiconductor devices): JPN exports = 15.0 percent of world exports. - HS 8703 (autos): JPN exports = 17.1 percent of world exports. ### The March 11, 2011 Earthquake: Supply-Chain Spillovers - Damage and power outages halted production of key inputs: car computers, integrated circuit chips, printed electronics boards. - Semiconductor and machinery concentration: - Japan represents one-fifth of the world's semiconductor production. - Japan accounts for more than a third of global exports of machinery and wafers (ISIC code 8486); provides more than 50 percent of U.S. imports and 35 percent of Chinese imports in that sector. - Specific vulnerabilities: - Japan controls 90 percent of world production of bismaleimide-triazine (BT) resin; Mitsubishi Gas and Chemical accounts for 50 percent of world supply and suspended production for two months. - Renesas, key MCU producer for automotive applications, operated at reduced capacity. - Short-term expected impacts: - Market analysts expected global car manufacturing to drop by up to 30 percent in the two months following the quake. - Expected to shave as much as ⅓ to ½ a percentage point off annualized U.S. GDP growth in Q2; losses expected to be offset in subsequent quarters. - Risks to normalization: - Semiconductor production requires stable electricity and clean water; prolonged power shortages would hamper normalization. - Medium-term implication: - Opportunities for regional firms to step up production of intermediate products and climb the value-added chain. ### Financial Markets: Largely Domestic - Japan‘s net international investment position: $3 trillion. - Private outward position: about $1½ trillion (primarily outward investments of banks, life insurers, and corporate pension funds). - Current-account surplus: around 3 percent of GDP. - Capital provision: Japan provides almost $200 billion of capital each year for other countries to borrow. - JGB and market participation: - Only 5 percent of JGBs are held by foreign investors; about one-fifth of those foreign holdings are located in Asia. - Foreign investors account for about 15 percent of cash turnover in JGBs and 65 percent of futures markets transactions. - Foreigners account for 42 percent of equity trading volumes; one quarter of equity market capitalization is held abroad. - Yen international metrics: - Yen holdings currently account for 2 percent of reported foreign exchange reserves. - Tokyo is the third largest foreign exchange market by turnover after London and New York. ### Growth Spillovers: A Regional Story - Empirical and model evidence: - VAR, input-output, IMF G-20 macro model, and GVAR indicate modest regional spillovers; larger effects confined to key regional partners. - Example: a one percent growth shock to Japan impacts Chinese output by about 18 basis points. - Input-output: a 10 percent increase in Japanese import demand would generate at most a ¼ percentage point export increase from its largest non-Asian trade partners. - Earthquake impact on growth (projection context): - Projected domestic output growth for 2011 downgraded substantially by around 2 percentage points. - Corresponding effect in Asia (including China) unlikely to exceed 0.1–0.3 percentage points of growth, ceteris paribus. - Summary: Growth spillovers from Japan are likely limited except for the United States; more noticeable for China, Korea, Indonesia. ### The Financial Channel: Generally Quiet - Financial-market shocks from Japan are limited in triggering global spillovers; Japanese financial variables do not trigger major spillovers, consistent with weak external financial-sector links. - Banking linkages and resilience: - Japanese banks‘ cross-border claims more than doubled from $1 trillion (2002) to more than $2½ trillion. - Claims by Japanese banks on Asia account for 10 percent of their total foreign claims. - The total international exposure of Japanese banks relative to GDP remains low compared with European banks. - BIS cross-border inter-bank exposures indicate global financial institutions fairly impervious to Japanese credit risk. - Stress and network analyses: - Network simulations show Japan could lose 57.6 percent (UK trigger) or 35.8 percent (US trigger) of pre-shock capital under an extreme credit shock (credit shock only). - In combined credit & funding shock scenarios many impacts become much larger (e.g., UK triggers -72.3 percent in the simulation rows). - Even a 45 percent withdrawal of interbank funding from Japan would not be expected to trigger systemic regional distress; most affected outside Japan would be the United Kingdom and the United States in global scenarios. ### Baseline: Fiscal Consolidation and Structural Reforms - Staff policy-adjustment baseline: - Medium-term fiscal consolidation starts in 2012 with a moderate tax increase to finance earthquake-related expenditures. - Staff estimates stabilizing net debt by 2016 and reducing it to around 135 percent of GDP by 2020 requires a 10 percent of GDP structural primary adjustment over the next ten years. - Structural reforms assumed to raise potential growth to 2 percent over the next decade. - GIMF simulation results (consumption percent difference: Short-term 5 years / Long-term 15 years): - USA: 0.6 / 1.1 - Euro area: 0.4 / 0.9 - Emerging Asia: 0.1 / 0.4 - Spillover mechanics: - Main international impact is release of a pool of savings for others to borrow; for Japan this implies a larger trade surplus and real depreciation. - Average impact on other economies is a ¼ percentage-point drop in their current account balance. - Asian economies with pegged exchange rates face additional short-term costs as yen depreciation translates into real appreciation, lowering inflation, pushing up real interest rates, and suppressing output. - Role of growth strategy and credibility: - Growth strategy can offset demand decline from consolidation and reduce short- to medium-term negative spillovers. - Credibility of the fiscal program limits demand-side costs; lack of credibility raises short-term costs and spillovers. ### A Rise in Long-Term Interest Rates - Vulnerability and sensitivity: - Growing debt stock increases vulnerability to upward movements in interest rates. - Banks hold over 40 percent of outstanding JGBs, accounting for one fifth of their total assets. - Total foreign holdings of JGBs amount to $390 billion. - Illustrative portfolio-shift scenario (Box 3): - Hypothetical: Japanese investors sell $500 billion of JGBs and purchase $200 billion of U.S. Treasury Bonds, $200 billion of German Bunds, and $100 billion of U.K. Gilts and other advanced-market bonds. - Estimated impact: raise Japanese interest rates by around 160 bps, while lowering yields elsewhere by around 40 bps. - Stress-test thresholds: - Japan’s top banks absorb a 300 bps hike in JGB yields without breaching an (aggregate) 8 percent core Tier 1 capital ratio. - A shock raising long-term government bond yields by about 450 bps would lead to a reduction in outward loans by 45 percent, assuming foreign loans are cut first. ### Spillovers to Foreign Banking Systems and Regional Financial Sectors - Network and stress-test highlights: - Bilateral exposure: Japanese banks mainly exposed to the U.S. and U.K.; among Asian countries exposures concentrated in Australia, South Korea and China. - Under an extreme scenario (λ=1, ρ=0.5, δ=2) Japan could fail owing to distress in various U.S. and European banking systems. - Impact on Japan if trigger country defaults (credit shock examples): - UK: -57.6 percent of pre-shock capital; US: -35.8 percent; Australia: -4.4 percent. - Impact on others if Japan defaults (credit shock examples): - UK: -25.3 percent; US: -9.6 percent; South Korea: -4.1 percent. - Megabanks stress-test (Tier 1 outcomes): - Scenario i (100bps): Tier 1 = 12.2 percent. - Scenario ii (200bps): Tier 1 = 10.6 percent. - Scenario iii (300bps): Tier 1 = 9.2 percent. - Scenario iv (400bps): Tier 1 = 7.8 percent. - Scenario v (Crisis, 450bps + other shocks): Tier 1 = 6.7 percent; restoring Tier 1 to 8 percent would require a 45.0 percent reduction in foreign loans. - Regional effects of a 45 percent reduction in Japanese interbank funding (impact as percent of pre-shock capital): - South Korea -13.6; Australia -8.6; Indonesia -5.2; Thailand -5.5; China -1.3; Taiwan -1.1. - Conclusion: regional impact limited in most cases; South Korea is most vulnerable in simulations but no regional banking system would be pushed to failure by a JGB-initiated shock. - Insurance sector stress-test: - Average solvency margin ratio of major insurers: 932 percent (minimum requirement 200 percent). - Scenario v (Crisis) solvency margin: 341.9 percent—still above regulatory minimum; insurers would not be forced to liquidate foreign positions. ### Monetary Policy Spillovers and Carry Trade Dynamics - Bank of Japan large-scale asset purchases (LSAP): - Event studies find modest local bond-yield effects (~15–25 bps) and little effect on term premium or exchange rate; U.S. and European markets largely unmoved. - Staff simulation of further LSAPs finds peak spillovers under 0.1 percent of GDP for other economies. - Carry trade prospects: - Historical precrisis carry trade estimates ranged from $100 billion to $2 trillion; current prospects for a return of the carry trade are weak. - Projection: average interest differential expected to widen by about 220 bps by end 2012, prompting an increase in the carry trade of around ¥4.3 Trillion ($51 billion); mapped effect could prompt a 5 percent depreciation of the yen against the AUD (5 percent may be an upper bound against other rates). - Conclusion: monetary easing in Japan (CME) has limited international spillovers; any revival of the carry trade depends on rising foreign rates and reduced volatility abroad. ### Trans-Pacific Partnership (TPP) — Impact of Japanese Membership - Authorities estimate net gain to Japan from TPP membership could amount to about ½ percentage point of additional output growth. - Staff CGE (GTAP) static analysis (selected marginal impacts of Japan joining TPP): - Japan: Real GDP gain 0.05 (All goods including Agriculture and processed Food); Export volume 3.25. - Vietnam: Real GDP gain 0.52; Export volume 11.68. - Malaysia: Real GDP gain 0.5; Export volume 1.99. - Korea: Real GDP gain 0.36; Export volume 3.84. - United States: Real GDP 0.00; Export volume 1.63. - Summary: TPP membership generates welfare gains for members, especially poorer members; inclusion of Japan raises benefits for many partners though some nonmembers may face losses from trade diversion. ### Debt Sustainability and Fiscal-Crisis Scenarios - Context and staff recommendation: - Government financing requirements around 50 percent of GDP. - Staff recommends a 10 percent of GDP improvement in the structural primary balance over the next 10 years to stabilize debt. - Fiscal-crisis scenario outcomes (selected peak GDP losses): - Scenario 1 (crisis contained in Japan): Japan 4.4 percent; Peripheral Europe 0.1 percent; Emerging Markets 0.4 percent; Other AM 0.2 percent. - Scenario 2 (spreads to European periphery): Japan 4.4 percent; Peripheral Europe 2.9 percent; Emerging Markets 0.5 percent; Other AM 0.3 percent. - Scenario 3 (spreads to periphery and emerging markets): Japan 4.8 percent; Peripheral Europe 3.2 percent; Emerging Markets 3.1 percent; Other AM 0.6 percent. - Policy risk: modest hikes in borrowing costs (example: 200 bps) could prevent stabilization even with recommended adjustments; rising yields could trigger adverse feedback loops. ### Overall Conclusions and Policy Implications - Empirical evidence shows limited recent policy spillovers from Japan despite its size; the earthquake highlighted Japan‘s critical role in intermediate inputs and technology for global production. - Risks elevated because many advanced economies are more vulnerable than during Japan‘s ―lost decade;‖ Japanese outcomes may have larger global impacts now. - Broad agreement on the need for a credible medium-term fiscal adjustment strategy to reduce vulnerability to a spike in JGB yields. - Benefits of credible fiscal consolidation for partner countries: - Medium- to long-term: release of savings for others to borrow and downward pressure on Japan‘s real exchange rate; lower world interest rates benefit all regions. - Short-run: Asian countries pegged to the dollar may face higher real interest rates and reduced output; speedy implementation of growth strategy would mitigate negative short-term spillovers. - Exchange-rate-related spillovers on foreign financial markets are small and depend on policy developments abroad. - Spillovers from regional trade agreements like the TPP would be slightly positive for participating countries. *International Monetary Fund: JAPAN 2011 SPILLOVER REPORT — CONCLUSIONS* ### CONCLUSIONS __________________________________________________________________________________ 20 ### CONCLUSIONS ### JAPAN’S ROLE IN THE WORLD ECONOMY - Japan is one of the largest and richest economies, benefiting from its rise as an export powerhouse in the second half of the 20th century. - Longstanding current account surpluses since the 1970s helped Japan become the world‘s largest net creditor. - The yen is a key international currency; several Japanese banks were at one time among the world‘s largest financial institutions. - The ―lost decade‖ of the 1990s, subsequent deleveraging of bank and corporate balance sheets, and adverse demographics have contributed to a more modest pace of economic expansion. ### Japanese Trade: High Value Added - Japan is a global supplier of high-end consumer goods and sophisticated intermediate products. - With the United States and China as its largest trading partners, Japan accounts for about 5 percent of world trade. - Japanese consumers rank among the most important buyers of finished products from Asia; Japan‘s imports from the region rank third in size behind China and the United States. - Japan‘s contribution to regional growth has slowed as domestic demand has stagnated in recent years. - Japanese technology facilitates exports of neighboring countries; Japanese exports have the lowest share of foreign value added in the region, underscoring Japan‘s ―upstream‖ position in the regional production chain. - Japan maintains a lead in specialized core components and captures a significant share of value added in other Asian countries‘ exports (example: Japanese companies account for about 10 percent of value added in Chinese exports of electrical equipment). ### The March 11, 2011 Earthquake: Supply-Chain Spillovers - The earthquake revealed Japan’s importance in the global supply chain: damage and power outages halted production of key ingredients for car computers, integrated circuit chips, and printed electronics boards. - Market analysts expected the number of cars manufactured worldwide to drop by up to 30 percent in the two months following the quake, and to shave as much as ⅓ to ½ a percentage point off annualized U.S. GDP growth in the second quarter; any loss was expected to be offset in subsequent quarters, resulting in little net impact for the year. - Japan represents, for example, one-fifth of the world's semiconductor production. - Japan accounts for more than a third of global exports of machinery and wafers (ISIC code 8486), providing more than 50 and 35 percent of U.S. and Chinese imports, respectively, in that sector. - The fragility of tightly integrated global-production networks is highlighted by specialization and concentration of upstream manufacturers; one small company with a single factory can have an 80 percent global market share in some inputs. - Specific vulnerabilities cited: - Japan controls 90 percent of the world‘s production of bismaleimide-triazine (BT) resin; Mitsubishi Gas and Chemical accounts for 50 percent of the world‘s supply and suspended production for two months. - Renesas, a critical producer of microcontroller units (MCU) used in automotive applications, was hard hit and operated at reduced capacity. - With few immediate alternatives and long lead times to build new facilities, firms absorbed losses by drawing down inventories or temporarily scaling back production. - Equity-price developments suggested the global impact would be short lived; analysts expected worldwide semiconductor production to pick up in July-September and largely normalize by the end of the year. - Downside risks remain, notably the speed of Japanese reconstruction and reinstallation of key infrastructure; semiconductor production requires stable electricity and clean water, and prolonged power shortages or blackouts would significantly hamper normalization. - Medium-term implications for other countries could include opportunities for regional firms to step up production of intermediate products and climb the value-added chain. ### Financial Markets: Largely Domestic - Japan has accumulated the world’s largest net foreign asset position: Japan‘s $3 trillion net international investment position reflects official reserves (mostly held in the form of U.S. Treasuries) and a large net private position in bonds. - The private position is about $1½ trillion, primarily outward investments of banks, life insurers, and corporate pension funds in U.S. Treasuries and both U.S. dollar and yen-denominated corporate bonds. - Japan still enjoys a current-account surplus of around 3 percent of GDP and provides almost $200 billion of capital each year for other countries to borrow. - Only 5 percent of Japanese government bonds (JGBs) are held by foreign investors; about one-fifth of those foreign holdings are located in Asia. - By comparison, more than 30 percent of U.S. Treasuries and around 55 percent of German bunds are held abroad. - Foreign investors account for about 15 percent of cash turnover in JGBs and 65 percent of futures markets transactions. - Equity market participation by foreigners is larger: one quarter of market capitalization is held abroad, but less than one-half of a percent is accounted for by Asian investors. - Foreigners account for 42 percent of equity trading volumes. ### Yen and International Role - The yen‘s share in global reserve holdings has declined over the past decade; yen holdings currently account for 2 percent of reported foreign exchange reserves. - Measured by turnover, the foreign exchange market in Tokyo is the third largest in the world after London and New York. - The yen has been a funding currency in foreign exchange carry trades and a preferred investment destination during bouts of global turmoil, contributing at times to abrupt currency movements in response to shifts in sentiment. - Recent earthquake-related worries about large-scale repatriation of capital initially resulted in a sharp yen appreciation, but yen volatility quickly diminished after a coordinated one-off intervention by the G7. ### Banks: Expanding Abroad Again - Banking links became less important since the 1990s, but Japanese banks are again expanding abroad as bank balance sheets slowly improve and domestic margins remain slim. - Japan‘s cross-border bank claims have more than doubled since 2002, from $1 trillion to more than $2½ trillion, mostly claims on the United States and other advanced economies. - The total international exposure of Japanese banks, measured relative to GDP, remains low compared with that of European banks. - Claims by Japanese banks on Asia account for only 10 percent of their total foreign claims and are concentrated in Australia and Korea. - Lending to the region is rising slowly; much of the expansion reflects loans to large Japanese firms and intra-firm transfers supporting regional FDI and trade. - Japanese banks face stiff competition from global competitors as they expand beyond their core Japanese corporate clientele. - The banking system appears relatively isolated internationally, suggesting limited bank-spillover channels. ### Key Statistics and Figures (as reported in the text) - Japan accounts for about 5 percent of world trade. - Japan‘s share of global GDP: about one-tenth (implied by figure text: "With almost one-tenth of global GDP..."). - Japan‘s net international investment position: $3 trillion. - Private outward position: about $1½ trillion. - Japan still enjoys a current-account surplus of around 3 percent of GDP. - Japan provides almost $200 billion of capital each year for other countries to borrow. - Cross-border bank claims: increased from $1 trillion (2002) to more than $2½ trillion. - Only 5 percent of JGBs are held by foreign investors. - Foreign holdings of JGBs: about one-fifth located in Asia. - Foreign participation: about 15 percent of cash turnover in JGBs; 65 percent of futures markets transactions. - Yen holdings currently account for 2 percent of reported foreign exchange reserves. - Japan accounts for one-fifth of the world's semiconductor production. - Expected drop in global car manufacturing: up to 30 percent in the two months following the quake. - Expected impact on annualized U.S. GDP growth in Q2: shave as much as ⅓ to ½ a percentage point. - Japan accounts for almost one-quarter of total advanced-economy FDI in Asia. - Bonds placed by Japanese issuers abroad amount to only 1½ percent of global outstanding cross-border debt securities. - Sum of gross capital inflows and outflows in the Japanese BOP: 14 percent of GDP. - Claims by Japanese banks on Asia: 10 percent of their total foreign claims. - Foreign investors account for 42 percent of equity trading volumes. *International Monetary Fund: JAPAN 2011 SPILLOVER REPORT — CONCLUSIONS* ### 12. This section expands on the stylized facts presented above. It reports the results of ### 12. This section expands on the stylized facts presented above. It reports the results of ### Growth Spillovers: A Regional Story - Empirical approach: - VAR model analyzing interactions between the United States, Europe, Japan, and the U.K. finds the impact of a growth shock in Japan is marginally positive on the Euro area; other effects are small and statistically insignificant. - Input-output analysis: a 10 percent increase in Japanese import demand would generate at most a ¼ percentage point export increase from its largest non-Asian trade partners. - IMF G-20 macroeconomic model: a one percent growth shock to Japan would impact Chinese output of the order of 18 basis points; a similar regional relationship is observed between the Euro Area and the United Kingdom. - Global Vector Autoregressive Model (GVAR) including growth, inflation, and other macro variables finds modest regional spillovers, including impacts on equity prices and interest rates. - Magnitude of earthquake impact on growth (projection context): - Projected domestic output growth for 2011 has been downgraded substantially by around 2 percentage points. - Ceteris paribus, corresponding effect in Asia (including China) is unlikely to exceed 0.1–0.3 percentage points of growth. - Summary conclusion: - Growth spillovers from Japan on the global economy are likely limited except for the United States; more noticeable impacts occur for key regional trading partners (China, Korea, Indonesia). ### The Financial Channel: Generally Quiet - Financial-market shock findings: - Shocks to U.S. bond yields and stock prices are noticeable in all global financial markets; Euro area equity impulses are felt in the United Kingdom and Japan. - Japanese financial variables are not found to trigger major spillovers, consistent with weak external financial-sector links. - Banking and credit linkages: - Japanese banks score low in market distress models; no Japanese bank appears among the global top 10 by estimated ability to generate distress. - BIS cross-border inter-bank exposures indicate global financial institutions are fairly impervious to Japanese credit risk; Japan is among the most resilient countries to cross-border credit shocks. - The impact of a hypothetical credit event in a Japanese bank would be comparable, by order of magnitude, to that of an average medium-sized European economy with low interest rate spreads. - Regional effects within Asia: - Network analysis: a scenario with a credit event and subsequent deleveraging could cause some Asian banking systems to experience moderate but not systemic losses. - Financial stress indices: financial stress in Japan could spill over into regional markets but the impact would be smaller than from other advanced economies; no spillovers appear from Japan to non-Asian emerging markets. ### Authorities’ Views - Broad agreement with staff findings, with caveats: - Authorities emphasized Japan remains an important source of demand for Asian trading partners. - Officials viewed empirical models as useful for growth and trade-based spillovers but were skeptical about models' capacity to capture financial market spillovers, particularly cross-border confidence effects. - Agreement that absence of empirical findings on financial spillovers should not be taken to mean Japan could not have a more significant impact during times of global economic and financial uncertainty. - Staff observation: - Current macroeconomic environment could make spillovers larger than empirical analysis captures; fragile advanced-economy outlook and constrained policy space increase potential global effects of negative developments in Japan. ### Policy Issues — Views Held by Other Authorities - Pre-earthquake international discussions focused on public debt dynamics: - General agreement that growth and financial spillovers from Japan were limited, but concern about fiscal imbalance and eventual unsustainability. - Transmission of a fiscal shock viewed as primarily through global financial markets rather than standard growth channels. - Noted that the carry trade from Japan had subsided, partially replaced by funding out of the United States. ### The Baseline: Fiscal Consolidation and Structural Reforms - Baseline scenario (staff policy-adjustment scenario): - Medium-term fiscal consolidation effort starts in 2012 with a moderate tax increase to finance earthquake-related expenditures. - Staff estimates that stabilizing the net debt ratio by 2016, and reducing it to around 135 percent of GDP by 2020, requires a 10 percent of GDP structural primary adjustment over the next ten years. - Structural reforms assumed to raise the potential growth rate to 2 percent over the next decade. - Model framework: - Policy simulations based on the IMF’s GIMF model. - Short run: fiscal adjustment reduces domestic demand. - Long run: lower public dissaving reduces interest rates, spurs investment, and boosts permanent income; growth-strategy reforms further spur investment and aggregate demand. - Spillover mechanics and magnitudes: - Main impact on other economies is release of a pool of savings for others to borrow; for Japan, increased savings translate into a larger trade surplus and real depreciation. - Average impact on other economies is a ¼ percentage-point drop in their current account balance. - For Asian countries with pegged exchange rates, fiscal consolidation generates additional short-term costs as yen depreciation translates into a real appreciation, lowering inflation, pushing up real interest rates, and suppressing output. - Long run: once fiscal consolidation is complete, all regions benefit from higher consumption and investment owing to lower world interest rates. - Policy-simulation consumption impacts (percent difference): - Short-term (5 years) / Long-term (15 years): - USA: 0.6 / 1.1 - Euro area: 0.4 / 0.9 - Emerging Asia: 0.1 / 0.4 - Role of growth strategy: - Growth strategy could offset decline in demand from fiscal consolidation, reducing negative spillovers in short- to medium-term by supporting consumption and investment and scaling back Japan’s trade surplus and depreciation. - Asian economies with rigid exchange rates may still face short-term output costs, though less than under pure fiscal consolidation. - Credibility effects: - Strengthening credibility of the fiscal program can limit demand-side costs; short-term costs of adjustment depend strongly on expectations of future productivity and income. - Uncertainty over long-term commitment would add to short-term drop in demand and exacerbate negative spillovers. ### A Rise in Long-Term Interest Rates - Vulnerability to rising yields: - Growing debt stock makes Japan’s fiscal position increasingly vulnerable to upward movements in interest rates. - Prospect of a shock seems remote given projected current account surpluses, net creditor status, and large foreign exchange reserves. - Delayed fiscal reform would increase risk of a rise in yields; private saving may decline with population aging. - Protracted slump in growth from earthquake disruption would exacerbate revenue shortfalls and market concerns about fiscal sustainability. - Potential transmission channels and magnitudes: - A rise in JGB yields from a spike in risk premia could induce capital losses on bond holders and possibly trigger deleveraging by Japanese banks. - Direct effect on foreign investors likely moderate given relatively small overall holdings. - Banks hold over 40 percent of outstanding JGBs, accounting for one fifth of their total assets. - Total foreign holdings of JGBs amount to $390 billion. - Box 3 — portfolio-shift illustrative scenario: - Hypothetical: Japanese investors sell $500 billion of JGBs and purchase $200 billion of U.S. Treasury Bonds, $200 billion of German Bunds, and $100 billion of U.K. Gilts and other advanced-market bonds. - Estimated impact: raise Japanese interest rates by around 160 bps, while lowering yields elsewhere by around 40 bps. - Stress-test and deleveraging thresholds: - Structural macroeconomic model stress test: Japan’s top banks absorb a 300 bps hike in JGB yields without breaching an (aggregate) 8 percent core Tier 1 capital ratio. - A hypothetical shock raising long-term government bond yields to the level of other large advanced economies (an increase of about 450 bps) would lead to a reduction in outward loans by 45 percent, assuming foreign loans are cut first. _Italic: Source — JAPAN 2011 SPILLOVER REPORT, INTERNATIONAL MONETARY FUND_ ### 29. Foreign banking systems would be ### _cr11183 - 29. Foreign banking systems would be ### Spillovers to foreign banking systems - Foreign banking systems would be expected to withstand such a deleveraging, given their relatively small exposure to Japanese banks. - Network analysis based on interbank flows identifies banks located in the United Kingdom and South Korea as most exposed by a loss in funding (Spillover Issues: Chapter X). - Authorities cautioned that, in an extreme scenario, the combination of higher JGB yields and counterparty risk could trigger a squeeze in foreign banks‘ Japanese derivatives operations, possibly requiring them to sell assets in other business areas. - Confidence effects of such a shock were hard to predict but could add to tensions in other wholesale markets. - Stress scenario: impact of a withdrawal of 45 percent of interbank funding from Japan measured as percent of pre-shock capital (figure described). ### Market-sentiment spillovers and sovereign distress transmission - An extreme value theory (EVT) framework provides only weak evidence that large movements in Japanese long-term interest rates prompt large movements in bonds and equity markets elsewhere (Spillover Issues: Chapter XI). - Conditional distress indicators (Spillover Issues: Chapter XII) suggest that the risk of transmission of sovereign debt shocks has increased considerably since the 2008 crisis, including from Japan to other sovereigns. - Both sides agreed that higher JGB yields could lead to higher interest rates elsewhere, especially in economies where public debt is already high. ### Comprehensive Monetary Easing (CME) and the yen - Scenario assumption: Bank of Japan continues CME policy for another 2 years. - Staff GIMF model result: monetary easing is expected to raise inflationary expectations and support demand by lowering real interest rates. - Estimated growth impact in Japan: raise growth by an average ½ percentage point over three years. - Spillover magnitude: hardly any spillovers—either positive or negative—would be seen abroad. Empirical and simulation findings: - Event-study analysis of the BoJ‘s large-scale asset purchases (LSAP) finds LSAPs have had a modest impact on local bond yields (around 15–25 bps) but little effect on the term premium or the exchange rate; financial markets in the United States and Europe have remained largely unmoved. - Staff simulation of further LSAP (assuming purchases continue up to the authorities‘ current allowable limit) finds spillovers are modest, with the peak impact on other economies ranging below 0.1 percent of GDP. - Any revival of the carry trade would depend on monetary policy abroad; cross-country interest differentials are at an historic low, and many other economies are expected to recover somewhat faster than Japan. - Forward-looking measures of risk-adjusted gains are significantly lower for the Australian, New Zealand, and U.S. dollar compared to the precrisis period, reflecting much narrower interest-rate differentials against the yen and a higher level of implied volatility priced into current markets owing to the crisis. - Position and leverage indicators suggest lower appetite for carry trades: prior to the crisis, noncommercial accounts held large short yen futures positions on the Chicago Mercantile Exchange; since Q4 2007, these accounts have mostly held net long positions. - Market observers judged a sudden return of the carry trade unlikely; as rates increase in the United States and elsewhere there might be growing interest in using the yen as a funding currency, putting further downward pressure on the exchange rate. - Staff simulations suggest the marginal impact on the currency is likely to be limited (Spillover Issues: Chapter XIII). Impact on trade patterns: - The impact of any CME-related depreciation would mostly occur outside Asia. - Simulations of a sizeable nominal effective depreciation on regional trading patterns—using a partial-equilibrium framework—find Asian trade responds relatively sluggishly, leaving Asia‘s role as Japan‘s dominant partner largely unchanged. - Trade with the United States and Europe is more sensitive to exchange rate changes (Spillover Issues: Chapter I). ### A Regional Trade Agreement (Trans-Pacific Partnership, TPP) - Authorities estimate net gain to Japan from TPP membership could amount to about ½ percentage point of additional output growth. - TPP could help entrench a rules-based framework for new trade areas such as medical services, pharmaceuticals, and insurance. - Staff CGE analysis results: - On average, without Japanese membership, the TPP would generate efficiency benefits equivalent to a one-time boost of 0.1 percent of GDP for regional members. - If Japan joins the partnership, these benefits increase to 0.2 percent (Spillover Issues: Chapter XIV). - Estimates reflect only static effects; gains could be considerably larger if increased competition and expansion of rules-based frameworks led to additional investment and productivity gains. Gains for TPP members from Japanese membership (percent change) - Real GDP / Export Volumes - Vietnam 0.52 / 2.08 - Malaysia 0.37 / 0.61 - Australia 0.05 / 0.92 - New Zealand 0.03 / 0.24 - Korea 0.03 / 1.71 - Singapore 0.00 / -0.06 - USA 0.00 / 0.65 - Chile 0.00 / 0.07 - Peru -0.10 / 0.22 ### Conclusions and policy implications - Empirical evidence: little evidence of significant policy spillovers from Japan in recent years despite Japan‘s size. - The recent earthquake highlighted the importance of Japanese intermediate inputs in global supply chains and Japanese technology as a key input for industrial production in many trading partners. - Japan remains an important and steady source of final demand for its Asian neighbors, but neither economic nor financial policies have had a significant growth impact on partner countries in recent years. - Risks and vulnerabilities: - Many other advanced economies have become more vulnerable than during Japan‘s ―lost decade,‖ so Japanese outcomes may have larger impacts now—both upside and downside. - Unsustainable fiscal trajectory in Japan has triggered concerns about public debt buildup; there is broad agreement on the need for a credible medium-term adjustment strategy. - Insufficient fiscal adjustment could lead to a spike in JGB yields which, even if effects were contained, could trigger financial volatility and prove highly disruptive. - Benefits of fiscal consolidation in Japan: - Medium- to long-term benefit for partner countries via release of a pool of savings for other countries to borrow and downward pressure on Japan‘s real exchange rate. - Short-run effect for Asian countries that peg to the dollar: might initially translate into higher real interest rates and reduced output. - Long-run effect: all regions benefit from lower world interest rates; speedy implementation of Japan‘s growth strategy would help offset negative short-term spillovers. - Exchange-rate-related spillovers on foreign financial markets are found to be small and depend partly on policy developments abroad. - Spillovers from regional trade agreements would be slightly positive for countries that joined the initiative. *Source: JAPAN 2011 SPILLOVER REPORT—SELECTED ISSUES (excerpt provided).* ### CHAPTER I. JAPAN’S ROLE IN REGIONAL TRADE ### CHAPTER I. JAPAN’S ROLE IN REGIONAL TRADE ### A. Changing Patterns in Japan’s Trade - Japan‘s intra-regional exports as a share of global GDP have remained remarkably stable—even during the crisis—and account for more than two-thirds of industrial countries‘ intra-regional trade. - Deepening regional integration largely driven by outsourcing of production by Japanese firms to neighboring countries, especially China, Hong Kong SAR, and Singapore. - Shift in export structure: - Share of high-technology goods in Japan‘s overall exports fell from 34 percent in 1995 to 23 percent in 2005. - Shift from export of high-tech final products toward sophisticated intermediate inputs, and outsourcing of low-tech stages to emerging Asian countries. - Japan established as important supplier of sophisticated manufacturing inputs globally and regionally, especially in the transport and electrical-machinery sectors. - Items with smaller shares in Japan‘s overall exports still account for a significant share of global exports in semiconductor and auto subsectors and are important inputs for Asian countries, United States, and European Union. - Rising similarity with export structures of emerging Asia: - Export similarity index (ESI) shows convergence of export structures of countries such as China and Thailand with Japan. - Competitive pressure from Korea has increased recently due in part to branding and marketing in China and other Asian countries. - Increased outsourcing and upstream positioning by Japan has facilitated technology-content shift to other Asian countries; rising similarity may reflect complementarity as well as competition. - Position in the supply chain: - Japan is upstream in Asian supply chain and an important source of foreign value added (FVA) in gross exports of other Asian countries. - Japan‘s contribution to FVA is especially high in countries engaged in assembly/processing (Singapore, Taiwan, China), particularly for high-tech exports such as electronic equipment and motor vehicles. - Implication: disruption in production of key intermediate inputs in Japan could spill over to other countries in the supply chain. - Role of Japanese FDI: - Vertical FDI by Japanese multinationals traditionally motivated by factor-price differentials (labor-cost arbitrage); U.S. FDI generally motivated by market-access considerations. - Labor-intensive stages (final assembly) moved to countries with lower unskilled labor costs; skilled-intensive activities (marketing, patenting, innovation) retained in headquarters. - Despite decline in share of Japan‘s high-technology exports, Japan retains aspects of production with highest value added. - Analysis of the iPod indicates the second largest share of value added is captured by Japanese firms producing high-value components. - Japan has consistently outperformed other G-7 countries in terms of increasing the income level of its exports (EXPY). - Table highlights (as presented): - Japan: Imported contents embodied in gross exports (2004) = 12.2; Indirect exports sent to third countries = 30.8; Upstream or downstream position (2)/(1) = 2.5. - EU-15: (1) = 11.4; (2) = 20.9; (3) = 1.8. - United States: (1) = 12.9; (2) = 26.9; (3) = 2.1. - Korea: (1) = 33.9; (2) = 23.1; (3) = 0.7. - China: (1) = 35.7; (2) = 12.5; (3) = 0.4. - Mexico: (1) = 48.0; (2) = 10.0; (3) = 0.2. - Japan's share in selected global markets (2010) for HS codes: - HS 8486, 8408, 8541, 8703: JPN exports (% world exports; reporting) = 34.3, 10.0, 15.0, 17.1 respectively. - Imports from Japan (% 4-digit imports): China = 35.7, 37.1, 19.6, 23.5; Hong Kong = 23.2, 7.6, 15.2, 30.6; India = 12.2, 10.0, 7.8, 15.0; Indonesia = 48.6, 31.1, 35.1, 20.1; South Korea = 40.6, 34.6, 25.3, 18.7; United States = 53.2, 20.2, 17.8, 27.7; EU27 (Ext Trade) = 27.2, 25.2, 6.4, 33.3. - Notes: 8486: Boilers and reactors: mach & appl for mnf semiconductors; 8408: Boilers and reactors: compression-Ignition for combustion engines; 8541: electrical machinery: semiconductor devices; 8703: vehicles excl railways: autos. - Sources of value-added for Asian countries' gross exports (electronic equipment; motor vehicles and parts) (2004): - CHN electronic equipment: Gross exports = 20,405; DVA = 60.5; FVA = 39.5; o/w JPN = 10.1. - CHN motor vehicles and parts: Gross exports = 65,002; DVA = 63.4; FVA = 36.6; o/w JPN = 8.8. - HKG electronic equipment: Gross exports = 1,156; DVA = 38.6; FVA = 61.4; o/w JPN = 16.9. - HKG motor vehicles and parts: Gross exports = 5,734; DVA = 79.7; FVA = 20.3; o/w JPN = 4.2. - IDN electronic equipment: Gross exports = 11,174; DVA = 44.1; FVA = 55.9; o/w JPN = 12.3. - ... (table continues for IND, KOR, MYS, PHL, SGP, THA, TWN, VNM with values preserved in table format of source). - Note: Gross exports are in millions of U.S. dollars; DVA = domestic value added share in gross exports; FVA = foreign value added share in gross exports; and o/w JPN = Japanese value added share in total FVA. ### B. Estimating Spillovers: A Sectoral Trade Elasticities Approach - Analytical framework: - Uses a simple model combining partial equilibrium approach with input-output analysis to analyze response of sectoral trade flows to changes in relative prices. - Simulation assumes a relative price decline that could arise from a 10 percent real depreciation; outlines changes in structure of Japanese trade across sectors owing to differences in import demand and substitution elasticities and in amount of imported intermediate goods. - Analysis does not model drivers of exchange rate changes and does not account for indirect supply-side effects such as inter-industry reallocation of production factors. - Data on imports at the 6-digit level used for full set of 162 countries where data available in COMTRADE. - Aggregate effects: - Assuming full pass-through of exchange rate changes to import prices, the Japanese trade balance improves by more than 3 percentage points of GDP, largely driven by a strong export response. - Large trade response reflects Japan‘s upstream position in the Asian supply chain and limited share of imported content in its exports. - This likely represents an upper bound; imperfect exchange rate pass-through and pricing-to-market likely mitigate adjustment; adjustment likely gradual given high fixed costs in production and trade relationships. - Sectoral effects: - A depreciation increases share of medium-high technology exports, largely driven by the auto sector. - Depreciation would reinforce Japan‘s comparative advantage in medium-high technology exports and allow recovery of relative specialization in the auto sector lost to countries such as Germany and France. - Medium-high technology exports generally more responsive to relative price changes, reflecting higher domestic value added and discretionary consumer character captured in income elasticities. - Supply chain effects: - Trade with Asian partners is less sensitive to relative price changes; trade-balance adjustment takes place mainly outside the supply chain. - In response to a depreciation, exports to (imports from) supply-chain partners would increase (decline) by a smaller amount compared to the rest of the world. - Net result: greater outward reorientation of Japanese trade beyond the region, and rebalancing with the rest of the world. - Effect is symmetric: in response to appreciation, trade with Asian partners would react less, resulting in greater regional reorientation of trade flows. - Illustrative quantitative outcomes (figures as presented): - Figure 4 shows percent changes in Exports and Imports by partner groups in response to relative price decline with axes spanning -8 to 22 percent for plotted categories (ROWIND, VNMIDN, HKGCHN, SGPMYS, PHLKOR, THATWN). - Figure 1: Intraregional Trade (exports in percent of world GDP) time series plotted for 1990–2009 for Japan, Ind Asia (ex JPN), NIEs, Emerging Asia. - Figure 3: Income Level of Exports--G7 (USD billions) time series plotted for 1990–2009 for JPN, CAN, DEU, FRA, GBR, ITA, USA. ### Regional Interdependence and Production Inducement (from Asian IO analysis) - Asian International Input-Output Tables cover 1995-2008 (published tables available until 2000; 2005 and 2008 tables extrapolated). - Production-inducement coefficients (PICs) capture production in a country induced by an additional unit of final demand in another country (based on inverse-Leontief matrix) and reflect strength of economic linkages through multiple rounds of intermediate trade. - Trends: - PICs attributed to foreign economies have risen in most cases, suggesting deepening interdependence. - Japan remains a key supplier of basic and capital-intensive parts/products at upstream stage of regional production chain. - Size and share of production induced by Japan has fallen over past 15 years but still sizeable at around 20 percent of total foreign inducement in 2008. - Degree of production inducement to NIEs3/ASEAN4 has remained constant; amount induced by China increased dramatically through 2000s. - Increase in overseas operations of Japan‘s multinational enterprises in Asia and technological progress of other Asian economies are consistent with observed shifts. - Value-added breakdown: - General increase in share of foreign value-added for most countries‘ exports indicates deepening trade integration. - Countries with higher foreign value-added share (e.g., China) focus more on assembly/processing and are downstream; Japan has high domestic value-added share (upstream) and contributes substantially to foreign value-added shares of other Asian countries’ exports. - Income dependence: - Japan is one of the region‘s largest consumer markets, following the United States. - Japan‘s share in regional income dependence has fallen recently; China has become the largest consumer market for NIEs3/ASEAN4, exceeding the United States in 2008. - Asian IO Table — Source of value-added in exports (selected values preserved from Table 1): - 1995 domestic value-added shares: JP = 95.6%; TW = 71.6%; CH = 86.0%; SG = 46.8%; ID = 90.9%; MY = 65.8%; PH = 82.7%; TH = 75.1%; KR = 80.5%. - 2005 domestic value-added shares: JP = 94.2%; TW = 71.8%; CH = 79.5%; SG = 38.1%; ID = 92.1%; MY = 58.4%; PH = 78.1%; TH = 72.5%; KR = 80.6%. - Asia (regional) shares and contributions by Japan and China to others' exports provided in the source tables for 1995 and 2005. ### C. Japan’s Outward Foreign Direct Investment (summary) - Japan‘s stock of outward FDI concentrated mainly in the United States, followed closely by Asia; since 2000, outward FDI moved progressively away from the United States towards Asia. - Euro Area continues to attract around one quarter of Japan‘s outward FDI. - Japan's outward FDI by region (billions of USD): - Total: 2001 = 300 (100); 2006 = 387 (100); 2009 = 741 (100). - Asia: 2001 = 53 (18); 2006 = 88 (23); 2009 = 176 (24). - P.R.China: 2001 = 10 (3); 2006 = 25 (6); 2009 = 55 (7). - North America: 2001 = 145 (48); 2006 = 156 (40); 2009 = 240 (32). - U.S.: 2001 = 140 (47); 2006 = 150 (39); 2009 = 231 (31). - Central and South America: 2001 = 21 (7); 2006 = 33 (9); 2009 = 99 (13). - Cayman Isl.: 2001 = 9 (3); 2006 = 18 (5); 2009 = 65 (9). - Middle East: 2001 = 1 (0); 2006 = 2 (0); 2009 = 4 (1). - Africa: 2001 = 1 (0); 2006 = 1 (0); 2009 = 6 (1). - EU: 2001 = 69 (23); 2006 = 92 (24); 2009 = 175 (24). - U.K.: 2001 = 33 (11); 2006 = 24 (6); 2009 = 31 (4). - Others: 2001 = 12 (4); 2006 = 16 (4); 2009 = 40 (5). - Oceania: 2001 = 8 (3); 2006 = 13 (3); 2009 = 36 (5). - Gravity-model evidence on determinants of Japanese outward FDI (panel OLS two-way fixed effects, 1989-2008, 129 economies): - Key results: - Coefficient on income differences (absolute difference in per capita GDP) is positive and statistically significant in all samples, suggesting labor-cost differentials (vertical integration) are a main driver of Japan‘s FDI. - Coefficient on host country GDP significant only for developing economies after 2000, suggesting market size recently became important for Japan‘s outward FDI. - Positive relationship between Japan‘s outward FDI and bilateral trade over full sample; relationship weakens in latter part of sample for developing economies, consistent with shift from FDI complementing trade to FDI aimed at servicing local markets (substituting for exports). - Selected regression coefficients and significance (from Table 2): - Difference in GDP per capita: coefficients include 2.310 **, 2.323 **, 2.003 **, 13.580 *, 13.311 *, 16.430 **, 38.631 ***, 37.511 ***, 39.934 *** (standard errors reported in source). - Bilateral trade (t-1): coefficients include 0.764 **, 0.710 **, 0.806 **, 0.723 *, 0.659 *, 0.541, 0.269, 0.250, 0.277. - GDP (host country): coefficients vary and become positive and significant in specifications for EMs/LICs in 1999-2008 (8.176 **, 9.538 ***, 7.832 **). - Number of observations and countries: e.g., Number of observations = 2301 (column (1)), Number of countries = 129; R2 values reported (e.g., 0.568). - Note: Variables transformed using semi-log procedure x = sign(x) log(1+|x|); a *, **, and *** represent statistical significance at 10, 5, and 1 percent respectively. *Prepared by Nagwa Riad (SPR) and Hitoshi Sasaki (SPR) based on IMF staff analysis in the referenced chapter.* ### CHAPTER IV. THE GLOBAL ROLE OF JAPAN’S CAPITAL MARKETS AND INVESTORS: STYLIZED ### CHAPTER IV. THE GLOBAL ROLE OF JAPAN’S CAPITAL MARKETS AND INVESTORS: STYLIZED FACTS ### Foreign investors in Japanese capital markets - Share of Japan's JGB holdings, 2009: - Govt 12% - Central Bank 7% - Fin. instit. 68% - Foreign 5% - Household 5% - others 3% - Origin of Foreign Bond Holdings, 2009 (Includes foreign holdings of corporate bonds): - US 14% - Europe 48% - Asia 17% - Other 21% - Share of Japan's equity holdings, 2010: - Fin. Instit. 24% - Foreign 24% - Nonfin. corporate 22% - household 20% - Invest. Trust 5% - others 5% - Origin of Foreign Equity Holdings, 2010: - US 54% - Europe 36% - Asia 2% - Other 8% - Stylized observations: - "Foreign JGB holdings are small......held mostly by US and European investors." - "Foreign equity holdings are somewhat larger......but very little is held by Asians." ### Foreign borrowers in Japan's capital markets - Trends and counts: - Number of listed firms in Japan's Equity Markets shown for 1990, 1995, 2000, 2005, 2009 (figure present). - "The number of listed foreign companies is declining... and the remaining few are mostly from the United States." - Bond issuance, 2000-10 (Trill. yen): - corporate bond issued (series plotted) - samurai bond issued (series plotted) - Samurai Bond Issuance, 2010 nationality composition: - Europe 55% - US 10% - Korea 12% - Australia 23% - Asia 35% (note: chart labels indicate samurai bond issuance is mostly from European residents) - Nationality of listed foreign companies (counts): - U.S. 6 - Cayman Island 2 - U.K. 1 - Spain 1 - Korea 1 - Malaysia 1 ### Japanese investors in foreign markets - Outward Portfolio Flows, Equity and Debt (2000–2009) shown by region (Latin America, Asia, Europe, US) in Trillion yen (figures plotted). - Japan's Portfolio Investment in the US (2003–2009) series: - US portfolio investment (liability) (A) - Japan's portfolio investment to US (B) - B/A (right scale) percent (series plotted) - Japanese Investment in Foreign Markets (percent of local market) plotted for Equity and Bonds. - Stylized observations: - "Japan's portfolio investment flows mainly to the US and Europe" - "Japan finances a sizable fraction of US funding from abroad... ...but has a minimal presence in Asia." *Prepared by Akira Otani (MCM) and Andrew Tiffin (SPR).* ### CHAPTER V. EXTRACTING AGGREGATE SPILLOVER INDICES FROM THE GVAR MODEL ### The GVAR model: structure and data - Model purpose: examine the role of unobserved global factors on country-specific variables. - Two-step estimation: 1. Construct individual country-level models where country variables (vector x) are functions of intercept α, time trend t, own lags, and contemporaneous and lagged trade-weighted averages x* of trading partners (equation (1) and (2) shown). 2. Combine individual models consistently to create a global model for impulse responses and forecasts. - Variables included: log of real GDP, inflation, real equity price, nominal exchange rate to the U.S. dollar, short and long-term interest rates and the oil price. - Coverage: 25 countries and the Euro Area. - Sample period: from 1979Q4 to 2009Q4. - Notes: - Euro Area variables are defined as a GDP weighted aggregate of eight countries: Austria, Belgium, Finland, France, Germany, Italy, Netherlands and Spain. - Not all variables are available for all countries and some missing data is interpolated from annual levels. ### Aggregate spillover indices: construction and interpretation - Construction (three-step procedure for every variable): 1. Subtract the total contribution of the variance of domestic variables from the total forecast error variance. 2. Add up the variance shares due to the variables of every particular country and divide them by the total contribution due to variance of foreign variables. 3. Normalize the resulting scores by subtracting the mean and dividing by standard deviation. - Interpretation: - The index shows the importance of all Japanese variables to the forecast error variance of a particular variable in all other countries. - When the aggregate spillover index is less (greater) than 0, Japanese variables contribute less (more) to forecast error variance than the average contribution of other trading partners. - Since the index is in terms of standard deviations, a number greater than 2 can be interpreted as high. ### Key results from the GVAR spillover analysis - When trade linkages are averaged over 1980–2009: - Japan's importance to its trading partners is higher than the importance of the average trading partner (Chart 1). - For some variables (output, inflation and real equity prices) the average aggregate spillover index is higher only relative to the region. - For exchange rate, short-term and long-term interest rate the situation is reversed (these variables are more linked with other advanced economies). - Time trends: - The importance of Japan to its trading partners has declined over time (Charts 2 and 3). - Focusing on the second half of the sample (1995–2009), Japan contributes less to the forecast error variance of its trading partners than the average country and its aggregate spillover indices are less than zero. - Cross-country rankings: - Among the S4 countries, Japan contributes mostly to the forecast error variances of inflation and exchange rate (Chart 4). - The Euro Area and the United States are by far the most important economies when compared to Japan or the United Kingdom. - Japan is generally ranked third after the United States and the Euro Area. *Prepared by Sergejs Saksonovs (SPR).* ### CHAPTER VI. GLOBAL AND REGIONAL BANK LINKAGES ### Methodology and data - Purpose: trace network spillovers from hypothetical credit events to specific banking systems. - Methodology: based on Espinosa-Vega and Solé (2010) network approach. - Data: BIS country-level bank exposure- and capital data for 26 countries (locational statistics as of September 2009). - Two simulations: 1. Credit shock: a banking system under distress unable to repay interbank loans to others. 2. Credit shock plus funding shock: distressed banking system unable to repay loans and unable to rollover funding to others. - Countries included: Australia, Austria, Belgium, Canada, France, Germany, Ireland, Italy, Japan, Netherlands, Portugal, Spain, Sweden, Switzerland, United Kingdom, United States, China, Taiwan, India, Indonesia, Malaysia, Philippines, South Korea, Thailand, and Vietnam. - Model parameters and scenarios referenced (example extreme scenario): λ=1, ρ=0.5, δ=2. Benchmark funding-shock sensitivity assumes δ=1, ρ=0.35. ### Bilateral exposures and regional linkages - Bilateral exposure patterns: - Japanese banks are mostly exposed to the U.S. and U.K. banking systems. - Among Asian countries, Japan's largest exposures are to Australia, South Korea and China. - Remaining Asian countries account for less than 1 percent of Japan's bank global exposures. - Among Asian countries, China, Taiwan and Australia are the main funding countries, but these linkages remain small. - Network simulation highlights: - Under the extreme scenario (λ=1, ρ=0.5, δ=2), there are eight instances in which Japan is expected to fail owing to distress in various U.S. and European banking systems. - Japan's banking system is expected to lose 57.6 percent (35.8 percent) of its pre-shock capital if the U.K. (U.S.) banking system suffers a credit event (Table 1). - If the event is combined with a funding shock, then the United States could trigger distress in Japan, but only in the third contagion round. - Among Asian countries, Japan is most at risk from Australia and South Korea, but the potential impairment is below 5 percent of the pre-shock capital of the Japanese banking system; the combined shock does not substantially increase the distress from these countries. - If Japanese banks become distressed, Australia and South Korea are most at risk; even under extreme circumstances, this is not expected to have systemic consequences in Asia, with the exception of South Korea, which could suffer a credit event owing to second-round contagion effects from European and the U.S. banks. - The most affected are the European and U.S. banks. ### Table 1 — Capital impairment (in percent of pre-shock capital) - Impact on Japan if trigger country defaults (Credit shock / Credit & Funding shock): - Australia -4.4 / -4.5 - France -6.2 / -72.3 - Germany -7.2 / -72.3 - Ireland -3.1 / -72.3 - Italy -0.5 / -72.3 - Portugal 0.0 / 0.0 - Spain -0.6 / -0.7 - UK -57.6 / -72.3 - US -35.8 / Full - China -1.6 / -1.9 - Taiwan -0.2 / -0.4 - India -0.4 / -0.5 - Indonesia -0.4 / -0.4 - Malaysia -0.2 / -0.2 - Philippines 0.0 / -0.1 - South Korea -3.1 / -3.2 - Thailand -0.6 / -0.6 - Vietnam -0.1 / -0.1 - Impact on others if Japan defaults (Credit shock / Credit & Funding shock): - Australia -2.2 / -8.8 - France -10.8 / -13.8 - Germany -2.6 / -7.2 - Ireland -10.5 / -11.7 - Italy -0.2 / -0.5 - Portugal 0.0 / -0.3 - Spain -0.8 / -1.5 - UK -25.3 / -39.7 - Full US -9.6 / -14.6 - China -1.3 / -2.2 - Taiwan -5.9 / -6.8 - India -0.2 / -1.3 - Indonesia -1.6 / -5.7 - Malaysia -1.4 / -3.0 - Philippines -5.4 / -6.0 - South Korea -4.1 / -14.7 - Thailand -2.9 / -7.2 - Vietnam -0.9 / -2.6 - Notes: - 1/ Assumes loss-given-default is 1. The figures represent the direct and indirect effects of failures. - 2/ "The results of this shock are highly sensitive to the choice of parameters. The benchmark assumes δ=1, ρ=0.35." *Prepared by Srobona Mitra (MCM).* ### CHAPTER VII. THE TRANSMISSION OF JAPANESE FINANCIAL-SECTOR STRESS ### FSI measure and approach - The IMF’s financial stress index (FSI) combines information on a country's securities, exchange markets, and banking sector into a composite, market-based index. - The FSI tracks market-price movements relative to past levels or trends and defines stress as the deviation from historical norms. - The FSI has been compiled for 17 advanced countries and 26 emerging economies using monthly data; a detailed description is provided in the 2009 Spring World Economic Outlook. - Two-step empirical approach to assess spillovers from Japan: 1. Extract a common stress component for Asian and other emerging economies (FSI-EM) from the common time effects of an unbalanced panel of emerging-economy stress indices from 1997–2010. 2. Regress the common time-component of emerging-economy stress on FSI-Japan, FSI-G6, and Global factors: - FSI-EM_t = f(FSI-Japan_t, FSI-G6_t, Global factors_t) ### Key findings on stress spillovers - Commonality: - Asian economies share a large common stress time-component: for Asian economies the common time-component explains about 80 percent of the time variation of the FSI across economies. - For other non-Asian emerging economies, the common component explains about 55 percent. - FSI subindices with strongest time co-movement: security and exchange markets. Banking-sector strain comovement is less common among emerging economies. - Magnitude and significance of spillovers: - A one standard-deviation increase in Japan's FSI raises financial stress in the region by around 0.2 standard deviations. - This effect is small relative to spillovers from other G7 economies (with coefficients of 0.3–0.5) but is robust to exclusion of the global crisis from the sample. - Stress spillovers from Japan to other emerging economies are small and not statistically significant. - Transmission speed and robustness: - Lag-structure tests indicate transmission of financial stress occurs within one month. - Robustness tests confirm results are not sensitive to changes in the method for extracting the common stress component, or to potential endogeneity of advanced-economy stress in the second-stage regression. ### Table 1 — Financial stress in Asian emerging economies (selected regression coefficients) - Dependent variable: common time component of financial stress index for emerging economies. EM Asia: China, India, Indonesia, Korea, Malaysia, Philippines, and Thailand. EM other: all other EMs including Brazil, Russia, Turkey, South Africa, and others. - Coefficients (with standard errors shown below each coefficient in table): - FSI_Japan: - Asia Whole sample: 0.44*** ( -0.048 ) - Asia Whole sample 1997-Pre Lehman: 0.15* ( -0.079 ) - Asia Whole sample (alternative column): 0.21** ( -0.096 ) - Other EMs Whole sample: 0.40*** ( -0.031 ) - Other EMs Whole sample 1997-Pre Lehman: 0.06 ( -0.043 ) - Other EMs alternative: 0.03 ( -0.045 ) - FSI_G6: - Asia Whole sample: 0.34*** ( -0.074 ) - Asia Whole sample 1997-Pre Lehman: 0.49*** ( -0.089 ) - Other EMs Whole sample: 0.40*** ( -0.04 ) - Other EMs Whole sample 1997-Pre Lehman: 0.52*** ( -0.042 ) - Libor: - Asia Whole sample: 0.22** ( -0.088 ) - Asia Whole sample 1997-Pre Lehman: 0.17** ( -0.083 ) - Asia Whole sample (alternative): 0.12 ( -0.099 ) - Other EMs alternative: 0 ( -0.057 ) - Other EMs Whole sample 1997-Pre Lehman: -0.05 ( -0.046 ) - Other EMs alternative: -0.14*** ( -0.046 ) - Commodity price index (log): - Asia coefficients: 1.68 ( -1.226 ), 1.67 ( -1.155 ), 0.9 ( -1.239 ) - Other EMs coefficients: -2.57*** ( -0.801 ), -2.60*** ( -0.63 ), -2.70*** ( -0.582 ) - Industrial production (log): - Asia coefficients: -16.80*** ( -4.098 ), -16.92*** ( -3.86 ), -15.94*** ( -3.98 ) - Other EMs coefficients: 0.91 ( -2.68 ), 0.77 ( -2.107 ), 0.49 ( -1.869 ) - Constant: - Asia Whole sample: 70.72*** ( -14.367 ) - Asia Whole sample 1997-Pre Lehman: 71.66*** ( -13.535 ) - Asia Whole sample alternative: 70.77*** ( -13.815 ) - Other EMs constants: 6.83 ( -9.394 ), 7.94 ( -7.386 ), 10.16 ( -6.486 ) - Sample sizes and fit: - Observations: 161, 161, 139, 161, 161, 139 (columns correspond to table columns) - R-squared: 0.515, 0.572, 0.591, 0.559, 0.729, 0.747 *Prepared by Stephan Danninger (APD).* ### CHAPTER VIII. GIMF SIMULATIONS OF FISCAL CONSOLIDATION AND GROWTH STRATEGY ### CHAPTER VIII. GIMF SIMULATIONS OF FISCAL CONSOLIDATION AND GROWTH STRATEGY ### Overview - Several scenarios are run to show spillovers from Japan’s policies to other regions using IMF’s Global Integrated Monetary and Fiscal model (GIMF). - Scenarios: financing earthquake-related expenditures and subsequent fiscal consolidation; spillovers from the authorities‘ growth strategy; joint implementation of consolidation and growth strategy. - General findings: - Fiscal reforms would benefit the rest of the world in the long term once adjustment is fully completed, but may involve short-term costs. - Medium-term and transition net effects depend on trade linkages, permanent-income effects, exchange-rate flexibility, and monetary accommodation. - Once adjustment is fully completed, lower long-term real interest rates supported by higher public savings would benefit all regions. - Some short-term negative spillovers could be eliminated by implementation of the growth strategy and monetary accommodation in Japan. - Model focuses mainly on macro-level trade channels; spillovers could be larger if supply-chain linkages and other financial contagion channels (such as carry trades) are considered. ### A. Fiscal Consolidation - Context and policy intent: - Government‘s Fiscal Management Strategy (June 2010) aims to halve the primary deficit by FY2015 and put the debt-to-GDP ratio on a downward path from FY2021 onwards. - Authorities’ social security reform plans (June 30, 2011) propose doubling the consumption tax to 10 percent in stages by the mid-2010s and using proceeds to fund social security; proposes raising pension retirement age and adjusting nominal pension benefits for deflation. - Staff analysis: stabilizing the net debt ratio by 2016 and reducing it to around 135 percent of GDP by 2020 would require a 10 percent of GDP adjustment in the structural primary balance starting in 2012. - Given limited scope for expenditure cuts, adjustment would need to rely mainly on new revenue sources and constraints on spending growth. - Consolidation scenario assumptions (gradual 10 percentage point increase in consumption tax): - Moderate increase could start in 2012. - Gradual but sustained fiscal consolidation starts in 2013. - Adjustment of about 2½ percent of GDP from expiry of fiscal stimulus package and modest expenditure adjustment (already in staff’s central WEO projections). - Phased consumption tax increase raising revenues by 5 percent of GDP. - Increase in personal income tax by ½ percent of GDP. - Corporate income tax lowered reducing revenues by ½ percent of GDP. - Decline in government consumption by 1¾ percent of GDP. - Decline in public investment by ¼ percent of GDP. - Remaining adjustment comes from transfers. - Package assumed fully credible and fully anticipated by private agents. - Simulation findings: - Short-run: - Fiscal adjustment would depress GDP growth for several years by about ½ percentage points relative to a non-adjustment scenario. - Increase in consumption tax, personal income tax, and lower government consumption and investment reduce domestic demand. - Some negative short-run effects can be offset by accommodative monetary policy in Japan (scenario assumes interest rates stay low for the initial two years). - Keeping nominal interest rates low while inflation returns to steady-state growth would lower short-run real interest rates. - Medium-run: - Real GDP could rise above the baseline depending on lower long-run real interest rates, fall in precautionary savings, switch to less distortionary corporate taxes, and confidence effects. - Fiscal consolidation increases the trade balance; overall savings increase, requiring a real depreciation of the yen. - Spillovers to other economies: - Relative to impact in Japan, spillovers are muted; largest impact on emerging Asia. - Exports decline in all regions due to lower demand from Japan. - Impact on imports and overall GDP depends on exchange rate flexibility and increase in domestic demand in other regions (esp. United States and Euro Area) arising from lower long-run interest rates. - Over next 5–10 years, Japan reduces demand for imports; net effect on regional GDP depends on monetary-policy response, permanent income effects in other regions, and exchange-rate flexibility. - Fixed exchange rate case for partners: tradable inflation declines, pulling up real interest rates, reducing domestic demand and imports, leading to GDP decline; negative impact lower for countries with restricted capital mobility. - Fully adjusting exchange rate case: real interest rates do not increase as much, dampening GDP impact. - In regions with modest trade linkages, permanent income effects dominate so lower real interest rates raise investment and consumption. - Long-run: once consolidation complete, world real interest rates are lower, pulling up investment and consumption in all regions. ### B. Growth Strategy - Scenario assumptions: - Trend growth gradually increases by about 1 percentage point over a 10 year period owing to productivity increases in tradable and nontradable sectors, and reductions in labor market mark-ups by 2 percentage points. - Government target: 2 percent real growth for the coming decade focusing on environment, health, Asian integration, and tourism. - Effects on Japan: - Broad-based productivity increase reduces Japan’s trade balance. - Higher productivity in tradable and nontradable sectors improves consumption and investment even in the short-run; associated currency appreciation leads to higher imports. - Spillovers to other economies (absent fiscal consolidation): - Short-run: all regions benefit through trade linkages with higher demand from Japan; short-term impact on real GDP depends on monetary policy reaction in the United States and the Euro Area—if monetary policy does not react to higher inflation in other regions, real GDP increases along with higher trade balance. - Medium- to long-run: all regions benefit from higher productivity and lower real interest rates, but benefits are relatively small without fiscal consolidation. - Benefits to Emerging Asia accrue over shorter horizons through trade linkages; benefits to other regions accrue over longer horizons. ### C. Combined Policy Package of Fiscal Consolidation and Growth Strategy - Structural reforms mitigate short-term negative effects from fiscal consolidation. - Structural reforms help Japan’s GDP increase gradually, limiting decline in imports and rise in current account surplus under fiscal consolidation, thereby reducing negative trade spillovers to the rest of the world. - Short-run growth spillovers from structural reforms depend on exchange rate and monetary policy responses; negative spillovers to emerging Asia could be significantly dampened through the trade channel. - Other regions benefit from lower real interest rates caused by credible fiscal consolidation and higher productivity, particularly over the medium-run. - Note: Improvement in emerging Asia‘s current account in some scenarios stems from import suppression due to higher real interest rates; with flexible exchange rates, import suppression is much less, dampening impact on emerging Asia‘s trade balance. *Prepared by Pelin Berkmen (APD).* --- ### CHAPTER IX. DEBT SUSTAINABILITY, BORROWING COSTS, AND THE IMPACT OF A FISCAL CRISIS ### A. Context - Earthquake interrupted Japan’s nascent recovery and increased focus on public debt dynamics. - Large fiscal deficits and sluggish activity have pushed public debt to unprecedented levels; government financing requirements around 50 percent of GDP, almost twice that of the United States. - JGB yields remain at historic lows, suggesting creditor confidence in authorities’ ability to stabilize. - Staff recommendation: a 10 percent of GDP improvement of the structural primary balance over the next 10 years to stabilize debt and place it on a downward path. - Debt-sustainability projections are highly sensitive to future interest rate path: - Example: with a 200 bps increase in borrowing costs, even the staff‘s recommended adjustment effort would fail to stabilize the public debt ratio. - Risk: modest hikes in borrowing costs could make implied fiscal burden of adjustment seem infeasible and trigger adverse feedback loops (rising yields → deteriorating fiscal situation → falling market confidence → more vulnerable financial system → contracting real economy). ### B. Fiscal Crisis Scenarios - Simulated a range of fiscal crisis scenarios originating in Japan using a refined structural macroeconometric world model (Vitek, 2010) featuring real and financial linkages within and across G20 economies. - Scenario 1: Fiscal crisis contained within Japan - Positive term-premium shock raises long-term nominal interest rate by 450 basis points on impact (bringing Japanese yields in line with other similarly rated sovereigns). - Equity risk-premium shock reduces equity prices by 60 percent on impact. - Households and firms postpone consumption and investment, decreasing domestic demand by 1 percent. - Fiscal consolidation reduces domestic demand by a further 2 percent. - Exchange-rate risk premium shock results in a 30 percent nominal effective depreciation on impact (run on the yen). - Estimated weighted-average peak output losses: - Japan: 4.4 percent - Peripheral Europe: 0.1 percent - Emerging Markets: 0.4 percent - Other Advanced Markets (Other AM): 0.2 percent - Scenario 2: Crisis spreads to European periphery - Adds shocks to foreign long-term nominal interest rates, equities, exchange rates, and demand for peripheral Europe. - Assumed shocks: - Japan: LT interest rates +450 bps; Equity prices 60 percent drop; Exchange rate 30 percent; Private demand 1 percent of GDP; Fiscal consolidation 2 percent of GDP. - Peripheral Europe: LT interest rates +300 bps; Equity prices 40 percent drop; Exchange rate 15 percent; Private demand 1 percent of GDP; Fiscal consolidation 1 percent of GDP. - Estimated weighted-average peak output losses: - Japan: 4.4 percent - Peripheral Europe: 2.9 percent - Emerging Markets: 0.5 percent - Other AM: 0.3 percent - Scenario 3: Crisis spreads to European periphery and emerging markets - Assumed shocks: - Japan: LT interest rates +450 bps; Equity prices 60 percent drop; Exchange rate 30 percent; Private demand 1 percent of GDP; Fiscal consolidation 2 percent of GDP. - Peripheral Europe: LT interest rates +300 bps; Equity prices 40 percent drop; Exchange rate 15 percent; Private demand 1 percent of GDP; Fiscal consolidation 1 percent of GDP. - Emerging Markets: LT interest rates +450 bps; Equity prices 60 percent drop; Exchange rate 30 percent; Private demand 1 percent of GDP. - Estimated weighted-average peak output losses: - Japan: 4.8 percent - Peripheral Europe: 3.2 percent - Emerging Markets: 3.1 percent - Other AM: 0.6 percent Table: Output Losses arising from a Fiscal Crisis (selected figures) - Scenario 1 peak GDP loss: Japan 4.4; Peripheral Europe 0.1; Emerging Markets 0.4; Other AM 0.2. - Scenario 2 peak GDP loss: Japan 4.4; Peripheral Europe 2.9; Emerging Markets 0.5; Other AM 0.3. - Scenario 3 peak GDP loss: Japan 4.8; Peripheral Europe 3.2; Emerging Markets 3.1; Other AM 0.6. *Prepared by Andrew Tiffin and Francis Vitek (SPR), and Kiichi Tokuoka (APD).* ### CHAPTER X. THE IMPACT OF A FISCAL CRISIS ON THE REGION: FINANCIAL-SECTOR ### CHAPTER X. THE IMPACT OF A FISCAL CRISIS ON THE REGION: FINANCIAL-SECTOR SPILLOVERS ### JGB holdings and cross-border exposure - Distribution of JGB holdings and foreign securities and loans across financial institutions (end-2010, financial institutions excluding the central bank): - Banks: JGB 60.8; Foreign Securities and Foreign loans 44.5 - Insurance: JGB 25.3; Foreign Securities and Foreign loans 23.4 - Pension Funds: JGB 4.7; Foreign Securities and Foreign loans 10.8 - Investment Trusts: JGB 1.9; Foreign Securities and Foreign loans 19.6 - Others: JGB 7.2; Foreign Securities and Foreign loans 1.7 - Total: JGB 100.0; Foreign Securities and Foreign loans 100.0 - Note: JGB is the sum of treasury discount bills, government securities and Fiscal Investment and Loan Program (FILP) bonds. All foreign loans are assumed to be conducted by banks. ### Effect of a JGB shock on the Japanese banking sector — stress-test design - Focus: three megabanks (MUFG, SMFG, Mizuho FG) which account for most of the banking sector‘s JGB and equity holdings and for most foreign loans. - Five stress scenarios: - Scenario i: 100bps parallel shift in the yield curve - Scenario ii: 200bps parallel shift - Scenario iii: 300bps parallel shift - Scenario iv: 400bps parallel shift - Scenario v (Crisis): fiscal-crisis scenario from Chapter IX — 450bps increase in interest rates, 60 percent decline in equity prices, and 4.4 percent decline in growth - Modeling notes: - Q-JEM (Quarterly Japanese Economic Model) used to estimate follow-on impact of interest-rate shocks on stock prices and GDP growth for scenarios i–iv. - Stress test estimates immediate losses on banks‘ JGB and equity holdings and expected losses in loan portfolio (Bank of Japan default rate function; three megabanks‘ core operating profits assumed same as 2010). - Tier I capital ratio recalculated assuming risk-weighted assets remain unchanged. - Drop in foreign lending estimated by assuming megabanks maintain an 8 percent targeted Tier I ratio by reducing foreign loans. ### TOPIX and credit cost rate assumptions (Fund staff estimates) - Table 2: TOPIX and credit cost rate in each scenario - Scenario i (-100bps-): TOPIX 828; Credit cost rate 50 bps - Scenario ii (-200bps-): TOPIX 722; Credit cost rate 60 bps - Scenario iii (-300bps-): TOPIX 629; Credit cost rate 72 bps - Scenario iv (-400bps-): TOPIX 549; Credit cost rate 85 bps - Scenario v (-Crisis-): TOPIX 392; Credit cost rate 101 bps ### Megabanks: stress-test results (Fund staff estimates) - Tier 1 ratio outcomes by scenario: - Scenario i (-100bps-): Tier 1 (%) 12.2 - Scenario ii (-200bps-): Tier 1 (%) 10.6 - Scenario iii (-300bps-): Tier 1 (%) 9.2 - Scenario iv (-400bps-): Tier 1 (%) 7.8 - Scenario v (-Crisis-): Tier 1 (%) 6.7 - Rate of reduction in foreign loans required to restore Tier I to 8 percent: - Scenario i: - - Scenario ii: - - Scenario iii: - - Scenario iv: -7.2 - Scenario v: -45.0 - Interpretation: - In scenarios i–iii Tier I ratios remain above 8 percent. - In scenario iv average Tier I ratio drops to 7.8 percent, prompting a slight scaling back of foreign loans to bring ratio back to 8 percent. - In the crisis scenario Tier I ratio drops to 6.7 percent (meets minimum requirement of 6 percent); to restore Tier I to 8 percent banks would need to reduce foreign loans by 45 percent. ### Regional spillovers from reduced Japanese foreign lending - Assumption: megabanks reduce foreign loans in proportion to their share of loans to each jurisdiction; local banks may sell assets at fire-sale prices (assumed 50 percent discount) in network analysis. - Impact on local banking systems from a 45 percent reduction of inter-bank funding from Japan — effect on capital (in percent of pre-shock capital): - Australia -8.6 - China -1.3 - Taiwan -1.1 - India -1.4 - Indonesia -5.2 - Malaysia -2.0 - Philippines -0.8 - South Korea -13.6 - Thailand -5.5 - Vietnam -2.2 - Regional interpretation: - Regional impact of a reduction in foreign loans is limited; effects on local banking systems are relatively minor when expressed as a fraction of total domestic credit, typically 0–2 percent. - Exceptions: Hong Kong SAR and Singapore (offshore financial centers) where impact ranges from 3–6 percent of total domestic credit; as cross-border intermediaries, local economic effect likely limited. - Network analysis finds that even a 45 percent withdrawal of Japanese funding would not be severe enough to trigger systemic distress in other countries. - Most vulnerable country: South Korea (could experience a 14 percent decline in pre-shock bank capital in the network simulation). Australia, Indonesia, and Thailand are also exposed to a limited extent. - No regional banking system would be pushed to failure by a JGB-initiated shock. ### Japanese presence in regional capital markets - Japan‘s equity holdings as a fraction of local market capitalization: - United States and Europe: ranging from 3–6 percent - Asia: 0–2 percent - Similar pattern applies to Japan‘s debt holdings. - Implication: withdrawal of Japanese investors from regional capital markets expected to have relatively small impact in Asia. ### Effect of a JGB shock on the insurance sector — stress-test results (Fund staff estimates) - Major insurance companies analyzed: Dai-ichi Life Insurance, Meiji Yasuda Insurance, MS&AD Insurance, Nippon Life Insurance, NKSJ, Tokyo Marine. - Assumptions: average maturity of JGBs is 10 years; average coupon rate is 1.2 percent. - Solvency margin ratio outcomes by scenario: - Scenario i (-100bps-): 871.7 - Scenario ii (-200bps-): 696.9 - Scenario iii (-300bps-): 532.8 - Scenario iv (-400bps-): 395/6 - Scenario v (-Crisis-) (%): 341.9 - Context: - Average solvency margin of the major firms is 932 percent, above the minimum requirement of 200 percent. - Even in the most severe scenario solvency margin ratio remains above 300 percent; JGB shocks would not force these insurers to reallocate assets or liquidate foreign investment positions. ### CHAPTER XI — Capital market contagion and extreme tail dependence (stylized facts and EVT approach) - Key stylized facts about correlations between extreme equity returns and bond-yield changes: - Large negative equity returns and large increases in bond yields are not necessarily correlated within major countries (U.S., Germany, Japan); greater correlations found in smaller countries such as Greece and Ireland. - Large negative shocks in equity returns are significantly correlated across countries, with correlations: - <0.30 with Japan - >0.6 within Europe - ~0.5 between U.S.-Canada and U.S.-U.K. - Large positive changes in 10-year bond yields are not very correlated across countries; no coincident yield-spikes in Japan and major countries at the 99th percentile tail. At the 95th percentile threshold (10-year yield change >18bps), small but significant correlations emerge with European countries (correlations between 0.2–0.3 between U.S.-France and U.S.-Germany; higher within Europe). - Extreme value theory (EVT) logit-regression approach: - Exceedances defined by tail thresholds (5th percentile tail for equity negative returns; 95th percentile for bond-yield increases). - Logistic regressions estimate probability that an exceedance in one country increases the probability of exceedance in another, controlling for MSCI-World returns, changes in VIX, extreme events in the euro-area periphery, and lagged dependent variables. - Four regression sets: bond-to-bond, equity-to-equity, bond-to-equity, equity-to-bond. - Summary of EVT regression findings: - Extremely large increases in 10-year JGB yields are associated with a higher likelihood of a hike in France‘s 10-year bond yields and, to a much smaller extent, the United States (Table 1). - Equity returns of European stock indices are more likely to be adversely affected than their 10-year bond yields, especially in France and Germany (Table 2). - Large negative equity returns in the Japanese stock index tend to be correlated with large negative returns in the United States, and to a much smaller extent, France (Table 3). - There is almost no impact of large negative equity returns on large increases in bond yields in advanced countries (Table 4). - When global equity markets (MSCI world) are doing better, chances of large negative equity returns fall for all countries, including Japan. - Some thin evidence that chances of a large change in yields increase when world equity markets are doing better (mainly Germany and the United States). - EVT thresholds and visual summaries: - Histogram threshold (5th percentile left tail) for week-on-week equity returns = -5.3% - Upper threshold (95th percentile) for week-on-week changes in 10-year bond yields = 18 bps ### CHAPTER XII — Assessing distress dependence among sovereigns (methodology and key observation) - Conditional probability of sovereign distress P(A|B) computed in three steps: - Extract marginal probabilities of distress P(A) and P(B) from individual-country CDS spreads (Bloomberg). - Obtain joint probability of distress P(A∩B) using Segoviano‘s non-parametric consistent information multivariate density optimizing methodology; the method ensures implied PoDs for each country match market-extracted PoDs without imposing a parametric copula. - Compute P(A|B) = P(A∩B) / P(B). - Features: - Joint distribution estimated for each date to produce time-varying pair-wise conditional probabilities. - For Japan, overall CoPods tend to be relatively low but elevate during global turmoil. - CoPods appear elevated for some European countries with perceived fiscal vulnerabilities and for some European banks. *Source: CHAPTER X. THE IMPACT OF A FISCAL CRISIS ON THE REGION: FINANCIAL-SECTOR SPILLOVERS (IMF staff chapter content).* ### CHAPTER XIII. MONETARY POLICY SPILLOVERS ### CHAPTER XIII. MONETARY POLICY SPILLOVERS ### The Local and International Impact of Large-Scale Asset Purchases - The Bank of Japan has pursued powerful monetary easing since Dec 2009, introducing a new fixed-rate provision of funds, an asset purchase program that involves government and corporate bonds, and equity exchange-traded funds and real estate trusts, and new growth-focused lending. - Event-study analysis suggests: - The easing has had a modest impact on local sovereign yields and equity returns. - The impact on corporate credit and economic activity is not yet clear. - The impact on the exchange rate, or on foreign markets, has not been significant. - Impact observations (qualitative summary from event studies and tables): - Local sovereign yields and equity returns: modest effects. - Corporate credit and economic activity: unclear. - Exchange rates and foreign markets: not significant. ### The Impact of Further Easing: Model Simulations - Simulations are based on a refined version of the structural G-20 model. - Scenario calibration: - Scales up event-study results, assuming authorities increase asset purchases up to the current allowable limit. - Results in a sequence of term premium shocks that reduce the long term nominal interest rate by around 50 basis points in Japan, and by 1–15 basis points in the rest of the world. - Equity markets in Japan rise by over 10 percent, matched by increases of 2–6 percent elsewhere. - Model constraints and assumptions: - Monetary policy is constrained by the zero lower bound on the short term nominal interest rate in the Euro Area, Japan, the United Kingdom, and the United States. - The simulation outcome is likely an upper bound, since a larger part of the impact of LSAP tends to be on announcement effects. ### Rising Interest Differentials and the Return of the Carry Trade - Historical context: - Prior to the global financial crisis, persistently low interest rates and historically low volatility made the yen a favored funding currency for carry trades. - The carry trade became a significant driver of cross-currency positioning in 2003–07. - In 2007, near the peak, estimates of the yen-funded carry trade ranged from $100 billion to $2 trillion. - Current conditions (assessment): - Prospects for a return of the carry trade do not seem strong relative to the precrisis period. - Forward-looking measures of risk-adjusted yields are relatively low for the Australian, New Zealand, and U.S. currencies; reflecting narrow interest-rate differentials against the yen and a higher level of implied volatility. - Only the Brazilian real appears to be climbing towards the elevated levels of 2008. - Position and leverage indicators suggest less capacity to hold yen-funded carry trades: - On the Chicago Mercantile Exchange, noncommercial traders are currently holding net long positions in the yen (whereas net short positions were the norm prior to the crisis). - Leverage indicators, such as call-money liabilities of foreign banks in Japan, suggest a significant decline in the trade's attractiveness. - Anecdotal reports indicate hedge funds and other speculative investors find it more difficult to build leverage in the post-Lehman shock environment. ### Forecasting the Carry Trade (Modeling and Determinants) - Indicator and methodology: - Net interoffice assets of foreign banks operating in Japan are used as an indicator of the scale of the yen-funded carry trade. - These net interoffice assets are modeled as a function of international policy-rate differentials (JPN vs. average of AUS/US/EUR) and the VIX. - Empirical specification notes (Table 4 highlights): - Interest Rate Differential coefficients (long-run): -37.281***, -22.828***, -37.499***, -36.695*** (various specifications). - VIX coefficients (long-run): -3.599***, -0.871*, -3.439***, -5.425*** (various specifications). - Post-Lehman interaction on the VIX is significant in some specifications (e.g., 3.916***, 2.891**). - Lagged dependent variable included in the dynamic specification with coefficient 0.826***. - R-sq values reported: 0.588, 0.362, 0.568 across specifications. - Number of observations: 110, 146, 146, 146 across columns. - Key empirical results: - Extending Shin‘s original regression to an updated dataset, the relationship with the VIX breaks down—potentially reflecting that after the Lehman shock, banks and hedge funds are more constrained in using their balance sheets for speculative purposes. - By including a post-Lehman interaction term on the VIX, Shin‘s original relationship is recovered. A similar interaction term on the interest differential, and a post-Lehman dummy, are both insignificant. - Residuals of the OLS specification suggest substantial autocorrelation; the preferred model therefore includes a lagged dependent variable. The choice of specification makes little material difference to the ultimate projection of net interoffice assets. ### Projections - Assumptions: - Japanese rates remain unchanged over the next two years. - Expected increase in policy rates abroad based on median forecast from Bloomberg. - Projection outcomes: - The average interest differential is expected to widen by about 220 bps by end 2012, prompting an increase in the carry trade of around ¥4.3 Trillion ($51 billion). - Mapping carry-trade change to exchange rates using the JPY/AUD relationship (VARX framework) yields: - The carry-trade increase is expected to prompt a 5 percent depreciation of the yen against the AUD. - The impact on other rates, such as the JPY/USD, is uncertain; 5 percent may be considered an upper bound against other rates. *Prepared by Phil de Imus, Andrew Tiffin and Francis Vitek (SPR); chapter content and tables as provided in the source PDF.* ### CHAPTER XIV. THE TRANSPACIFIC PARTNERSHIP AGREEMENT—IMPACT ON JAPAN AND OTHER ### CHAPTER XIV. THE TRANSPACIFIC PARTNERSHIP AGREEMENT—IMPACT ON JAPAN AND OTHER MEMBERS ### Background and scope - Origin: 2006 Economic Partnership Agreement among Brunei, Chile, New Zealand and Singapore; expanded in 2010 to include the United States, Australia, Malaysia, Peru, and Vietnam. Japan, Korea, Thailand, Canada and Mexico have expressed interest. - Objective: A high-standard, 21st century trade agreement covering all aspects of trade and investment; seen as a starting point for a broader Free Trade Area of the Asia-Pacific (FTAAP). - Japan: Announced intention to join TPP in June 2010 as part of a new growth strategy to open the country and revitalize agriculture. - Negotiation timeline: Sixth Round in April 2011 (Singapore) included U.S. proposals on labor rights, environmental protection, intellectual property, and a first-time legal text on regulatory coherence. Plan was for TPP to be concluded during the APEC leaders meeting hosted by the United States in November 2011. ### Key proposals and contentious areas - Coverage: Trade liberalization would extend to all chapters of the Harmonized System, including agriculture and processed food. - Services: Strong focus on services liberalization—of particular interest to U.S. service suppliers. - New issues tabled (April 2011): labor rights, environmental protection, intellectual property protection, and regulatory coherence. - Regulatory coherence: Aimed at making regulatory systems operate more seamlessly and addressing behind-the-border issues; may establish oversight regulatory bodies analogous to the U.S. Office of Information and Regulatory Affairs (OIRA). ### Methodology of impact assessment - Model: Global Trade Analysis Project (GTAP), latest version used (version 7); base year 2004. - Nature of analysis: Static analysis capturing economic efficiency impact of tariff removal only; no dynamic adjustments for capital accumulation or productivity improvements. - Coverage of analysis: Follows Wignaraja (2011) framework covering 10 countries (GTAP excludes Brunei); scenarios consider coverage (with and without agriculture liberalization) and membership (with and without Japan). - Outcomes measured: One-time effects on Real GDP, Export volume, and Utility per capita (from expenditures). ### Key empirical findings (summary) - General: - TPP membership generates welfare gains for Japan and most other members, especially if agriculture is included. - Potential losses for nonmembers are higher when Japan is included due to higher trade diversion. - Broadening membership of the FTA generates more gains; production in sectors with comparative advantage will increase under the FTA. - Japan: - Marginal one-time real GDP increase from TPP membership (including agriculture): about 0.05 percent. - Marginal one-time export volume increase for Japan (including agriculture): more than 3 percent. - Distribution of gains: - Projected welfare gains are highest for Vietnam and Malaysia; poorer members gain more from FTAs. - Marginal contribution of Japan‘s membership in terms of a one-time increase in real GDP ranges from 0.5 percent for Vietnam to 0.03 percent for Korea (note: this sentence in source text; see detailed table values below). - Comparison with dynamic studies: - Results are qualitatively similar to Kawasaki (2010) but much smaller in magnitude because Kawasaki allows for dynamic capital formation and productivity improvements. ### Selected detailed results from GTAP (marginal impact of Japan's membership — TPP with JPN) - Japan (TPP with JPN — All goods excluding Agriculture and processed Food): - Real GDP: 0.02 - Export volume: 0.93 - Utility per capita from expenditures: 0.14 - Japan (TPP with JPN — All goods including Agriculture and processed Food): - Real GDP: 0.05 - Export volume: 3.25 - Utility per capita from expenditures: 0.11 - Vietnam (TPP with JPN — All goods excluding Agriculture and processed Food): - Real GDP: 1.1 - Export volume: 9.95 - Utility per capita from expenditures: 2.99 - Vietnam (TPP with JPN — All goods including Agriculture and processed Food): - Real GDP: 1.02 - Export volume: 11.68 - Utility per capita from expenditures: 5.72 - Malaysia (TPP with JPN — All goods excluding Agriculture and processed Food): - Real GDP: 0.4 - Export volume: 1.65 - Utility per capita from expenditures: 1.43 - Malaysia (TPP with JPN — All goods including Agriculture and processed Food): - Real GDP: 0.5 - Export volume: 1.99 - Utility per capita from expenditures: 1.34 - Korea (TPP with JPN — All goods excluding Agriculture and processed Food): - Real GDP: 0.08 - Export volume: 3.1 - Utility per capita from expenditures: 0.29 - Korea (TPP with JPN — All goods including Agriculture and processed Food): - Real GDP: 0.36 - Export volume: 3.84 - Utility per capita from expenditures: 0.39 - United States (TPP with JPN): - All goods excluding Agriculture and processed Food — Real GDP: 0, Export volume: 1.21, Utility per capita: 0 - All goods including Agriculture and processed Food — Real GDP: 0, Export volume: 1.63, Utility per capita: 0.04 - Selected negative impacts (TPP with JPN): - Cambodia (KHM) — All goods excluding Agriculture: Real GDP: -0.11, Export volume: -0.2, Utility: -0.85 - Thailand (THA) — All goods including Agriculture: Real GDP: -0.11, Export volume: 1.18, Utility: -0.91 - China (CHN) — All goods including Agriculture: Real GDP: -0.04, Export volume: -0.28, Utility: -0.22 (Note: full country-level tables available in the source; above are selected entries reproduced exactly as in the source tables.) ### Comparison: TPP without Japan (selected entries) - Japan (TPP without JPN): - All goods excluding Agriculture and processed Food — Real GDP: 0, Export volume: 0.06, Utility per capita: -0.03 - All goods including Agriculture and processed Food — Real GDP: 0, Export volume: 0.12, Utility per capita: -0.03 - Vietnam (TPP without JPN): - All goods excluding Agriculture and processed Food — Real GDP: 0.63, Export volume: 7.87, Utility per capita: 2.44 - All goods including Agriculture and processed Food — Real GDP: 0.5, Export volume: 9.6, Utility per capita: 5.12 ### Gains from Japan joining (TPP with JPN − TPP without JPN) — selected entries - Japan: - All goods excluding Agriculture and processed Food — Real GDP: 0.02, Export volume: 0.87, Utility per capita: 0.17 - All goods including Agriculture and processed Food — Real GDP: 0.05, Export volume: 3.13, Utility per capita: 0.14 - Vietnam: - All goods excluding Agriculture and processed Food — Real GDP: 0.47, Export volume: 2.08, Utility per capita: 0.55 - All goods including Agriculture and processed Food — Real GDP: 0.52, Export volume: 2.08, Utility per capita: 0.60 - Malaysia: - All goods excluding Agriculture and processed Food — Real GDP: 0.36, Export volume: 0.62, Utility per capita: 0.6 - All goods including Agriculture and processed Food — Real GDP: 0.37, Export volume: 0.61, Utility per capita: 0.57 - Australia: - All goods excluding Agriculture and processed Food — Real GDP: 0.02, Export volume: 0.64, Utility per capita: -0.03 - All goods including Agriculture and processed Food — Real GDP: 0.05, Export volume: 0.92, Utility per capita: 0.40 - Korea: - All goods excluding Agriculture and processed Food — Real GDP: 0.01, Export volume: 1.61, Utility per capita: -0.17 - All goods including Agriculture and processed Food — Real GDP: 0.03, Export volume: 1.71, Utility per capita: -0.17 - United States: - All goods excluding Agriculture and processed Food — Real GDP: 0.00, Export volume: 0.41, Utility per capita: -0.02 - All goods including Agriculture and processed Food — Real GDP: 0.00, Export volume: 0.65, Utility per capita: 0.02 ### Preliminary considerations and policy implications (as stated in source) - Positive welfare impact: Empirical analysis suggests a positive welfare impact from membership for Japan and other Asian countries. - Competitive dynamics: Korea has been active on the FTA front and could have FTAs in place with the United States by the end of 2011 and with the European Union and China by 2012; Japanese export sectors risk competitive disadvantage from a widening tariff gap. - Financial liberalization: Financial liberalization is a key feature of TPP; Japanese financial institutions could benefit from improved access to rapidly growing emerging nations' financial markets. --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11183.pdf_